Lack Of Clarity On Pre-Trade Transparency Vexes

By Mike Kentz


Differences in opinion between the Securities and Exchange Commission and the Commodity

Futures Trading Commission regarding the nature of swap execution facilities are slowing the

pace of regulations and drawing the ire of market participants. Mike Kentz explains.


The request-for-quote system of trading an over-the counter derivative allows end users to customizea trade and find out which dealer will give the best price without any other entities knowing their identity or desired trade. Most market participants consider the system vital to the health of the OTC market. Dodd Frank’s call for pre-trade transparency and the coming creation and use of swap execution facilities is running the risk of dismantling that system.

 The CFTC and the SEC have been tasked with defining swap execution facility and how it will function. They differ widely when it comes to the format for RFQs.

 The CFTC has published a proposal which says end users placing an RFQ will have to post each request to five different dealers every time. The SEC has proposed RFQs will only be required to be posted to one dealer at a time. The CFTC’s rules will apply to index-based credit default swaps and interest rate swaps while the SEC’s rules will apply to single name CDS.

 Another layer to this regulatory disparity is the pace and form with which each Commission is attacking the rules. The CFTC has finalized over 25 rules to the SEC’s two to this point, according to their website, with market participants largely split between supporting the ‘Slow and steady’ SEC and the ‘Let’s get going’ CFTC. “The Commission and staff are working hard to adopt effective rules as quickly as possible, with an emphasis on getting the rules right,” said an SEC spokesman. “The CFTC’s on a quicker track and on the whole we think that’s a good thing,” said Jim Rucker, chief credit and risk officer at MarketAxess in New York, a planned SEF for both index and single name CDS. “There’s considerable uncertainty, [and that] makes it difficult to make business decisions to introduce the changes that we eventually will need to.”

 Regardless of the time frame, large institutions like BlackRock and MetLife are crying foul, saying that the CFTC five-dealer requirement will lead to banks front-running their trades. “SEFs should be allowed to structure their RFQ platforms on whatever basis the SEF believes will serve its clients’ interests, whether one-to-one or one–to-five,” wroteJoanne Medero and Richard Prager of BlackRock in a comment letter back in June.

“The requirement that participants solicit bids and offers from at least five swap dealers would not only fail to meaningfully increase price discovery, but would likely diminish it, particularly in markets with a limited number of market makers,” wrote Todd Lurie of MetLife.

 But it wouldn’t be a debate without a flip side. Dodd-Frank wasn’t written to protect the incumbency of big banks and large institutions. It was written to safeguard the market and increase competition, meaning smaller players get to see the same prices bigger players do (via a SEF).

 “[A] system that permits request for quotes from only one market participant would facilitate abusive trading practices such as prearranged trading and ‘painting the screen,’” wrote James Cawley, co-founder of the Swaps and Derivatives Markets Association and head of planned SEF Javelin Capital Markets, in a comment letter. Painting the screen means posting inaccurate prices for personal gain.

 With this type of pressure coming from all angles, it’s no wonder the regulators appear to be buckling under the pressure. In late February, the CFTC delayed a final vote on the definition of the term ‘swap dealer’ because the SEC wasn’t ready, according to reports. One market participant said he has had separate conversations with high-ranking officials at both Commissions where the officials blamed their counterparts for the slow pace of rule implementation.

 When the regulators do get to a final vote on SEFs, which will be in April at the earliest, the question with respect to RFQs is what rule will both protect a customer trading illiquid swaps while also guaranteeing pre-trade price transparency and increased competition.

 Javelin, for one, plans to offer anonymous RFQ and anonymous request-for-market options. Anonymous RFQ means the customer puts in a request for pricing on a customized trade but does not include its name. Anonymous request-for-market means the customer withholds both name and the direction of the trade. That means the customer asks forboth sides of a particular trade, including the size, but without the name. That way, conceptually, there will be no clear opportunity for front-running and less risk of ‘painting the screen.’

 Rucker at MarketAxess said his firm was “working on facilitating things to make that happen, but we’re not ready,” adding that the firm would wait for more regulatory clarity. Tradeweb, a provider of multi-dealer credit default swap and interest rate swap execution and another planned SEF, “is not currently planning” to offer ARFQ or ARFM. The reason, they said, is that their clients have not asked for that functionality and they would wait until it became a regulatory requirement before taking such steps.

 TeraExchange, which is planning to execute all CDS and IRS, is “bypassing [the] RFQ model and rolling out a fully anonymous central limit order book” for non-block trades, said Christian Martin, ceo at the firm in Summit, N.J.Bloomberg’s AllQ platform for index-based CDS and IRS will “adapt the platform to the SEF protocols once they have been finalized.” Ben MacDonald, global head of fixed income trading, products, and services at Bloomberg in New York, added the firm views the five-dealer requirement as “problematic.”

 As for the SEC, whose low public profile to this point has unnerved some market participants, the market will wait to see if their ‘one-to-one’ SEF trading requirement changes either. Officials familiar with the regulatory discussions said the SEC is satisfied with its approach and that the one-to-one requirement doesn’t preclude or require the use of ARFQ or ARFM, though a spokesman declined comment.

 Lost in the shuffle of all this lobbying is the concept that many OTC market participants may begin to exit the stage left to populate the futures market no matter what. SEFs, regardless of a buyer’s ability to cloak its name and trade direction in an RFQ, may struggle with the ability to confirm trades in real-time considering each customer will have the choice as to which clearinghouse they use. That concept of vertical integration is something the futures market can still boast.